Know the goal before choosing the risk

Let's say you do the right thing and, before investing your money, you define your objectives -- a nest egg for retirement, for example, or a college fund for your kids. You pick your investments based on your time horizon -- how long before you will spend the money -- and on how much risk you can tolerate. So far so good, but that's not good enough. You can still foul things up badly if you -- as I suspect is true of most people -- don't have a clue what rate of return you need to achieve your goals.

And if you don't know, one of two bad things is likely to happen. Either you take excessive risks shooting for returns higher than what you need or you invest too conservatively not knowing you need a higher return, and fall short of your goals.

So what rate of return do you need? I lay heavy odds you don't know. "It's actually fairly rare that a person knows," said Paul Merriman, a veteran investment adviser in Seattle.

If you don't know, you are in good company. In his monthly newsletter, Merriman tells of a financial writer for a national publication -- mercifully, he does not identify her -- who asked for his opinion on the investments she and her husband had made.

Merriman said the investments seemed "quite aggressive," so he asked the writer what return she and her husband needed to meet their objectives. She said she thought it was from 12 percent to 15 percent, compounded annually. "When we ran the numbers, it turned out they could meet their goals with a 6 percent return," Merriman said. "But because they had not figured this out, they were taking a lot of unnecessary risk, including the chance that they could lose substantially and have to start over again.

"And this is somebody who spends all her time writing about investing," Merriman said.

And last year, at a conference of certified public accountants, Merriman asked a roomful of CPAs the rate of return they needed on their investments. "Less than 10 percent of them raised their hands," Merriman said. "And these people were at this conference because they were interested in becoming investment advisers."

So why is it that so many people don't know? I suspect it is because the answer involves some tedious number crunching and forces you to think long and hard about your needs and wants.

First, you must set a specific goal of how much money you need and when. Then, based on how much you have already saved and how much more you can add, you calculate the required rate of return.

Let's say you plan to retire at 66 and have determined you will need $500,000 to supplement your pension and Social Security benefits. You are 46, have $50,000 set aside for retirement and can afford to save $200 a month.

To get to $500,000 in 20 years, you will need a 9.8 percent average annual compounded rate of return. But if you save $300 instead of $200 a month, your required return would be less than 9 percent. If you save only $100, your return would have to be 10.6 percent.

A financial calculator lets you get the numbers in a jiffy and allows you to play with "what if" scenarios -- what if I saved more, or decided to retire later, for instance.

But you still have to carefully analyze your income and expenses to determine how much you can put away now and will eventually need.

"To find out what you need requires work, and work is of course something many people don't want to do," Merriman said.

For people who have saved consistently, Merriman said, an 8 percent annual compounded rate of return is typically sufficient to meet their needs. Of course, each case has to be calculated individually.

At an 8 percent gain compounded annually, the value of an investment doubles approximately every nine years. And, according to my calculator, you could withdraw $3,644 a month for 30 years from a $500,000 nest egg compounding at 8 percent a year before it is depleted.

Such withdrawals, however, could be sustained only if the 8 percent return is consistent. If returns fluctuate sharply -- up one year and down the next -- and heavy losses occur early on, the nest egg could be wiped out much sooner.

Humberto Cruz can be reached at AskHumberto@aol.com or c/o Tribune Media Services, 435 N. Michigan Ave., Suite 1500, Chicago, IL 60611. Questions will be addressed through his columns but personal replies are not possible.